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Retirement Perspectives

Here is a guide to new IRS regulations that allow plan owners to take money out of their 401(k) in the event of a financial hardship.

Readers of this column know that a 401(k) is designed to be used for retirement income only. An account owner is allowed to withdraw assets from their 401(k) plan if they separate from their employer, reach age 59½ or retire. But what if the owner becomes ill or disabled, or experiences a financial hardship while employed, and needs money to pay for living expenses?

Fortunately, account owners are allowed to tap their 401(k) or 403(b) if they meet certain hardship conditions set by the Internal Revenue Service (IRS). On September 19, 2019, the IRS published final regulations for taking a distribution on account of financial hardship from a 401(k) or 403(b) plan. The final regulations are pursuant to changes to hardship distribution rules contained in the 2018 Bipartisan Budget Act (BBA).

The changes made by the BBA are positive, in our view, and include (1) expanding the sources of funds available for hardship distribution; (2) eliminating the requirement a plan participant to first take a plan loan prior to taking a hardship distribution; (3) eliminating the requirement salary deferrals be suspended for six months following hardship distribution; (4) adding a new type of hardship expense relating to a federally declared disaster area.

Below, we cover the rules covering hardship distributions and briefly describe the recently published changes.

Is a hardship distribution from a 401(k) plan taxable?
If the account owner is employed by the company sponsoring the 401(k) and needs to access funds to alleviate the financial hardship, they may be able to do so via a plan loan or hardship distribution. The employer determines whether to offer these options as a plan provision. The exception gives the plan participant access to plan funds that ordinarily would not be available for distribution.

While any defined-contribution plan can offer loans, only 401(k), 403(b), and 457(b) plans can offer hardship distributions. An all too common mistake on the part of plan participants is thinking that distributions taken on account of financial hardship are tax and penalty free. Distributions on account of a hardship are taxable unless your withdrawal comes from Roth contributions and if you’re under age 59½ subject to the 10% early distribution penalty tax. In other words, financial hardship is not an exception to the 10% penalty. Finally, you can’t roll over your hardship withdrawal to an IRA or back into the plan.

What about IRA distributions in hardship situations?

IRA distribution rules are extremely liberal, thus allowing access to your IRA funds at any age or time and for any reason—although taxes and penalties will apply. A distribution of IRA funds prior to age 59½ is subject to the 10% early distribution penalty when no other exception applies. Hardship is not an exception to the penalty. Further, funds are subject to income tax unless the distribution contains basis or is qualified Roth IRA distribution.

What is considered a hardship?
A 401(k) or 403(b) hardship must be made "on account of an immediate and heavy” financial need. In addition, the distribution must be necessary to satisfy the financial need. Therefore an employer has the option to use safe harbor rules (common) or may rely on “facts and circumstances.” Finally, you must represent to the plan that you don’t have enough funds or other liquid assets to cover the expense.

Here are the IRS safe harbor rules and acceptable conditions:

  1. Medical expenses for the participant, their spouse, or dependents
  2. Cost related to the purchase of a principal residence
  3. Tuition, fees, and room and board expenses for the next 12 months of postsecondary education for you, or your spouse, children, dependents or plan beneficiary.
  4. Payments necessary to prevent eviction from, or foreclosure on, a principal residence
  5. Certain burial or funeral expenses for the participant, their parents, spouse or dependents
  6. Expenses for the repair of a principal residence
  7. Federally Declared Disaster Area. The final regulations added a new safe harbor if a person incurs “expenses and losses” at a principal residence during a disaster. This new provision may be applied to distributions made on or after January 1, 2018.

In 457(b) plans, a hardship distribution must be made "on account of an unforeseeable emergency." Although slightly different, all the IRS safe harbor hardships reasons qualify under a 457(b) except (1) purchase of a home and (2) tuition-related expenses. These expenses do not qualify as “unforeseeable emergencies" and are generally not eligible for hardship from a 457(b) plan. However, unlike pre-age 59½ hardship distributions from a 401(k), distributions from a 457(b) plan are always exempt from the 10% early distribution penalty.

What has changed in the hardship distribution rules?
In the new financial hardship rules, the BBA expanded the sources of funds available for a hardship withdrawal. Now, withdrawals can include earnings on elective deferrals, qualified non-elective contributions (QNECs) and qualified matching contributions (QMACs). Hardship distributions previously were limited to the total amount of 401(k) elective deferrals—not including earnings made the plan.  In 403(b) plans, amounts eligible for distribution due to hardship are more limited. For instance, earnings on 403(b) salary deferrals continue to be ineligible for a hardship distribution and QNECs and QMACs held in a 403(b)(7) custodial account continue to be ineligible for a hardship distribution.

Previously (pre-BBA), it was required to take a loan before withdrawing funds from the plan for a hardship. The new regulations allow the option of retaining or eliminating the requirement that plan loans must be taken prior to receiving a hardship distribution—effective for plan years beginning after December 31, 2018.

Also, prior to the BBA, you couldn’t get a hardship withdrawal unless the plan suspended you from making salary deferrals (pretax, Roth or aftertax) for a minimum of six months. The BBA eliminated the employee deferral suspension rule.

The new hardship distribution rules apply to distributions taken on or after January 1, 2020. However plan sponsors may elect to apply the new rules to hardship distributions taken in plan years beginning after December 31, 2018.  Its expected  that plan sponsors will need to amend their plans’ hardship distribution provisions to reflect the final regulations, and any such amendment must be effective for distributions beginning no later than January 1, 2020.

Before an account owner considers taking a hardship withdrawal from a 401(k), we recommend that the owner speaks to their financial advisor and/or accountant.

 

To comply with Treasury Department regulations, we inform you that, unless otherwise expressly indicated, any tax information contained herein is not intended or written to be used, and cannot be used, for the purpose of (i) avoiding penalties that may be imposed under the Internal Revenue Code or any other applicable tax law, or (ii) promoting, marketing, or recommending to another party any transaction, arrangement, or other matter.

The information is being provided for general educational purposes only and is not intended to provide legal or tax advice. You should consult your own legal or tax advisor for guidance on regulatory compliance matters. Any examples provided are for informational purposes only and are not intended to be reflective of actual results and are not indicative of any particular client situation.

The information provided is not directed at any investor or category of investors and is provided solely as general information about Lord Abbett's products and services and to otherwise provide general investment education. None of the information provided should be regarded as a suggestion to engage in or refrain from any investment-related course of action as neither Lord Abbett nor its affiliates are undertaking to provide impartial investment advice, act as an impartial adviser, or give advice in a fiduciary capacity. If you are an individual retirement investor, contact your financial advisor or other fiduciary about whether any given investment idea, strategy, product or service may be appropriate for your circumstances.

GLOSSARY OF TERMS

Traditional IRA contributions plus earnings, interest, dividends, and capital gains may compound tax-deferred until you withdraw them as retirement income. Amounts withdrawn from traditional IRA plans are generally included as taxable income in the year received and may be subject to 10% federal tax penalties if withdrawn prior to age 59½, unless an exception applies.

A Roth IRA is a tax-deferred and potentially tax-free savings plan available to all working individuals and their spouses who meet the IRS income requirements. Distributions, including accumulated earnings, may be made tax-free if the account has been held at least five years and the individual is at least 59½, or if any of the IRS exceptions apply. Contributions to a Roth IRA are not tax deductible, but withdrawals during retirement are generally tax-free.

401(k) is a qualified plan established by employers to which eligible employees may make salary deferral (salary reduction) contributions on an aftertax and/or pretax basis. Employers offering a 401(k) plan may make matching or nonelective contributions to the plan on behalf of eligible employees and may also add a profit-sharing feature to the plan. Earnings accrue on a tax-deferred basis.

A 403(b) plan is a retirement savings plan that allows employees of public schools, nonprofit, and 501(c)(3) tax-exempt organizations to invest on a pretax and or Roth aftertax basis. Contributions to a 403(b) plan are conveniently deducted directly from your paycheck. In addition, your employer may elect to make a contribution on your behalf.

A governmental 457(b) deferred-compensation plan allows employees of states, political subdivisions of a state, or any agency or instrumentality of a state to invest money on a pretax or Roth aftertax basis through salary reductions. The employer deposits amounts withheld into an annuity, custodial, or a trust account, where the funds accumulate tax-deferred or potentially tax free in the case of Roth aftertax contributions until withdrawals commence, usually at retirement.

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